Texas Hedge ‘Em

Having tested the limits of credulity so far this year, the markets may now be set to test our patience. We had the worst first week to a year for equities ever, then the worst two months. It is only natural that some kind of bounceback is due, of which we have started to see a little since the middle of February. The tricky part now is that far from treading water, digesting the year so far, running valuation models and deciding to dip toes into the waters of our favourite long-term investments, we may find another danger hoves into view. Galumphing like an elephant, here comes the smack back of a period of volatility: when the insurance you bought for the bad times starts to eat into your profits in the good times.

Yes, buying insurance isn’t just a one-off insurance premium cost. Those insurance products also get marked to market. This means that when volatility falls, it can cause a position squeeze even on the positions bought just to sit there in case of the black swan. The point here, folks, is that market implied vols are set to drop significantly. For example, plenty of people tried to deal with the risk of a China blow-up by buying options on USD/CNH. Now that devaluation risks are receding, these options simply can’t be as valuable. Why own 1month implied volatility at 9% when the realised volatility over that period has actually been just 6%? This divergence can’t last when realised volatility starts to fall sharply:

CNH implied vs realised

Others bought forwards on pegged currency regimes, to try to own some insurance in case the currency wars spilt into a de-pegging currency crisis for the Saudi Riyal or Hong Kong Dollar for example. Those forwards points spiked into the end of January but have come off ever since:

HKD and SAR fwds

Does that mean this risk has left us? That Saudi Arabia is out of the woods? That all of the reasons to feel fearful about its economy in the depths of an oil price catastrophe have disappeared? No, it just means that it’s not as valuable because everyone already owns it.

If you’re a long term investor you might think that these oscillations are just short-term, irrelevant, squeezes of speculators. They put on a Texas hedge: squeezed on their core positions in the bad times, now squeezed on their insurance positions in the good times. Why worry – this kind of price action just provides you with better opportunities to pick up bargains, does it not?

Unfortunately not. The world of Bobby’s Nightmare means that volatility is just as dangerous on the way down as it is on the way up. Just as we overshoot into panic, we are going to look as if we overshoot into greed. Market based volatilities are often used as signals to increase/decrease risk. The world of “risk on/risk off” has been with us ever since correlations between assets went to 1 in the Lehman world. Markets take their signals from other markets. Equities look at the oil price; bond traders look at the Chinese currency; credit traders look at the Japanese yen (and for an excellent blog piece on that last point, check this @Macronomics). So the absence of new fear doesn’t necessarily mean calmer markets with narrower ranges: it could turn into a circle that feeds on itself whereby it looks like a powerful greed-fuelled risk-on rally. The moves so far this year have taken our breath away. They can do that with an even more breathtaking reversal back in the opposite direction.

 

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